ICAI Corporate Valuation

12
CORPORATE VALUATION
LEARNING OUTCOMES
After going through the chapter student shall be able to understand
❑ Conceptual Framework of Valuation
❑ Approaches/ Methods of Valuation
(a) Assets Based Valuation Model
(b) Earning Based Models
(c) Cash Flow Based Models
❑ Measuring Cost of Equity
- Capital Asset Pricing Model (CAPM)
- Arbitrage Pricing Theory
- Estimating Beta and Valuation of Unlisted Companies
❑ Relative Valuation
❑ Other Approaches to Value Measurement
- Contemporary Approaches to Valuation
- Chop Shop Method
- Economic Value Added (EVA)
- Market Value Added (MVA)
- Shareholder Value Analysis (SVA)
❑ Arriving at Fair Value
© The Institute of Chartered Accountants of India

12.2 STRATEGIC FINANCIAL MANAGEMENT
1. CONCEPTUAL FRAMEWORK OF VALUATION

The syllabus of this paper requires you to have expert knowledge of various techniques of
valuation of various securities (e.g. equity shares, preference shares and bonds etc.) as well as of
business. While the topic of Valuation of Securities we discussed earlier now we shall discuss the
topic of ‘Valuation of Business’ that too in corporate context. Though Corporate Valuation can be
carried out for various purpose but here we shall mainly using the same for the Mergers and
Acquisitions decisions, the next topic for the discussion.
The basic purpose of any enterprise is to earn profits in order to sustain itself and promote growth.
Managements across the world endeavor in this aspect – be it be a sole proprietorship concern or
a multinational giant having its foothold across geographies.
Corporate valuation can be traced back to centuries ago when the United East India Company
(referred to as ‘Dutch East India Company’ by the Britishers) was the first corporation to be valued
and an IPO was launched. The East India Company too stands as a fine example of a corporatized
way of doing world trade, and perhaps the earliest of institutions to focus on wealth maximization,
albeit in unethical ways. Today, almost every enterprise that generates a positive cash flow and
generates suitable employment opportunities feels the pressing need to ‘value’ itself – be it for
going to the local bank for debt financing, or for assessing an initial public offering.
It is obvious that the more an enterprise grows, the more the number of stakeholders it adds in its
progress to growth. Presentation of annual financial statements in the annual body meeting,
publishing quarterly results for the street – all these become the staple diet for stakeholders who
sow the seeds of capital in the enterprise and in turn, wait for the enterprise to multiply its
progressive potencies. In a relative world, this persisting curiosity of the stakeholders to
understand the ‘true worth’ of their enterprise becomes translated to the concept of ‘valuation’. Add
to it, the market analysts, financial intermediaries, and let’s not forget the academicians, and what
we have is a handful of valuation approaches that have been painstakingly and meticulously
crafted for valuing the correct worth of the enterprise at hand. In a true sense, valuation imbibes
both the science and the art of itself per se. As it stands today, valuation has become an
inseparable part of strategic financial management.
To elaborate, the need of a proper assessment of an enterprise’s value can be typically for:
(a) Information for its internal stakeholders,
(b) Comparison with similar enterprises for understanding management efficiency,
(c) Future public listing of the enterprise,
(d) Strategic planning, for e.g. finding out the value driver of the enterprise, or for a correct
deployment of surplus cash,
(e) Ball park price (i.e. an approximate price) for acquisition, etc.

CORPORATE VALUATION 712.3
2. IMPORTANT TERMS ASSOCIATED WITH VALUATION

It’s imperative to understand the important terms that we would come across and will be used
widely in any valuation model. Some of the terms have indeed evolved over a period of time and
continued usage, and now stand on their own as precursor to application of the actual valuation
model itself.
2.1 The Concept of PV (Present Value) of cash flows
Needless to state that all student must have referred and understood thoroughly the concept of
‘Time Value of Money’ at Intermediate Level in the paper of Financial Management. Accordingly, a
receipt of ` 1,000 twelve months hence would not be the same as of today, because of concept of
Time Value of Money and the discounted value of ` 1,000 a year at the rate of 10% shall be ` 909
approximately.
2.2 The Concept of IRR (Internal Rate of Return)
Similar to above this concept has also been discussed in the paper of Strategic Financial
Management at Intermediate Level. IRR is the discount rate that will equate the present value
(NPV) of all cash flows from a particular investment or project to zero. We can also visualize IRR
as a discount rate that will get the PVs of cash inflows equal to the investment.
The Decision Rule – the higher the IRR of a project, the more likely it gets selected for further
investments.
2.3 ROI (Return on investment)
Simply put, ROI is the return over the investment made in an entity from a stakeholder point of
view.
A simple example would be where the stakeholder has sold shares valued at 1400, invested
initially at 1000; the ROI would be the return divided by the investment cost, which would be
(1400-1000)/1000 = 40% in this case. You would have noted that the 40% is the return on cash
investment for this standalone transaction, primarily signifying the absolute rate of return on
liquidating his holdings. But if the stakeholder sells his shares that was held by him from the past
several years, he would try to calculate the ROI by taking into account the time value of money.
This would imply that the ROI gets ‘adjusted’ over the period of his holdings. So, if a stakeholder
had worth 1000 of shares at the beginning of the year and he makes an additional investment of
200 during the year, and his investment is valued at 2000 at the end of the year, his ROI would be
calculated as returns divided by the average investment held during the year. His returns would be
(2000-1200 = 800) and the average investment would be [(1000+1200)/2] = 1100 for the year.
Accordingly, his ROI will be 800/1100 = 72%. The average cost of investments is arrived at to
recognize the timing of the investment. In this case, the stakeholder may also calculate the actual
days of the additional investment, to arrive at the exact ROI. However, stakeholders who are
multiple investments and portfolios will use the average cost of investments as illustrated above.

From an entity’s point of view, the most significant use of ROI would be to calculate the returns
generated by each individual / incremental investment on a project or different projects. Thus, a
company that has initiated a couple of projects during the year towards new business lines can
implement the ROI concept to calculate the returns on the investment and take further decisions
based on the same. Note that ROI is a historical ratio, so naturally the decision can either only be
a course corrective action, or channeling further investments into the more successful business
line.
By now you will appreciate that essentially, we are viewing ROI as a performance measure ratio in
the corporate scenario; which also brings us to an interesting question –how about measuring
returns against the total investments, or simply put, the total ‘assets’ held by the enterprise? After
all, it is imperative that all assets are put forth and only for the purpose of wealth maximization and
fullest returns, right? And that’s precisely the concepts seen below.
2.4 Perpetual Growth Rate (Gordon Model)
As discussed in the chapter of Cost of Capital at Intermediate Level the Gordon’s model assumes
a perpetual growth in dividend; thereby potential investor eyeing stable inflows will take the latest
Dividend payout and factor it with his expected rate of return.
This model is not widely used by potential investors because of following reasons:
(i) there are more parameters which need to be factored in, and
(ii) dividends rarely grow perpetually at a steady rate.
However, this model is the darling of academicians as it can neatly fit into a ‘constant rate’ model
for deliberation purposes.
2.5 The term ‘TV’ (Terminal Value)
Terminal’ refers to the ‘end’ of something – in the valuation world, to ‘terminate’ would be to exit
out of a particular investment or line of business. So, when an investor decides to pull out and
book profits, he would not only be expecting a fair value of the value created, but also would
definitely look to the ‘horizon’ and evaluate the future cash flows, to incorporate them into his
‘selling price’. Hence, Terminal Value (TV) is also referred to as the ‘Horizon Value’ that the
investor forecasts for valuing his investment at the exit point. Mostly TV is estimated using a
perpetual growth model as per the Gordon model. We will see the practical usage of TV in the
various questions/ illustrations during the study of this Paper.
3. APPROACHES/ METHODS OF VALUATION

As mentioned earlier one of the purpose of the valuation is Mergers and Acquisitions as the
carrying out valuation of target company becomes important to gauge out the price to be of fered to
it. The target company can be listed or unlisted. If the target company is unlisted then the price of
acquisition shall be at the negotiated price acceptable by both companies. For listed companies

stock market value or market capitalization can form the basis of valuation of target company.
Though stock market price is a guide to the acquiring company but it does not give an estimate
how much the target company is worth as stock price will also depend on Market Efficiency.
Further in some cases even small portion of total shares is quoted and hence market price
represents a marginal portion of overall capital. This calls for further analysis of valuation of target
company.
As mentioned earlier the valuation of securities especially valuation of equity shares has been
covered in chapter on Security Valuation in this chapter we shall focus on methods of valuation
other than discussed in the chapter on Security Valuation.
Broadly there are three approaches to value an enterprise:
(a) Assets Based Valuation Model
(b) Earning Based Models
(c) Cash Flow Based Models
In addition to the above there are some other methods. First let’s see above three methods in
detail as below:
3.1 Asset Based Approach
Being a straight forward method, the value of shares of target company is computed in terms of
net assets acquired. This method of valuation is not based on income generation rather than on
income generating assets.
This method is least important in case of IT companies where ‘hard’ assets make little im portance
as these companies’ assets are intellectual property rights and human resources.
This approach further can be classified into following three methods:
3.1.1 Net Asset Value
The most simplest method also called ‘Book Value’ Method computes the valu e of the shares of
the company as follows:
Net Fixed Asset = Fixed Assets + Net Current Assets – Long Term Debt
Though this method as advantage of being simplest as it uses historical costs which are easily
available but it has little relevance as Balance Sheet is not a valuation device. Therefore, this
method offers a loser limit to value the shares of target company.
Further this method ignores the current asset valuation even for intangible assets such as Brand,
Intellectual Property Rights etc.

3.1.2 Net Realizable Value

Also called Liquidation Value or Adjusted Book Value it can be defined as realizable value of all
assets after deduction of liquidation expenses and paying off liabilities. Though in some case
liquidation expenses can be ignored if business of target company is acquired as a going concern.
Despite appearing to be simple method the calculation of net realizable value may not be so
simple as being an off-market purchase it is likely that buyer may offer lowest prices.
This method is not so popular as it involves total break up of the target company. This method is
generally useful where the acquirer is interested in selling one part of business and integrate
remaining part of the business with the existing operations.
In the below example we see that the realizable values are different as compared to the book
values:
Book Values Net Realizable Values
Long Term Debt
(Term Loan from ZB Bank) 10,000 10,000
Current Liabilities 10,000 10,000
Total Liabilities (A) 20,000 20,000
Non-Current Assets (B)

PPE 50,000 40,000
30,000
Licenses 10,000 60,000 70,000
Current Assets (C)

Sundry Debtors 50,000 45,000
10,000
Cash 10,000 60,000 55,000
Net Assets (B) + (C) – (A) 1,00,000 1,05,000

Thus, total net realizable assets of the net book value of ` 1,00,000 in the above example would
` 105,000 and if there are 5000 equity shares then the value of per share will be ` 21.
3.1.3 Replaceable Value
This method involves valuation as per determination of the cost of group of assets and liabilities of
equivalent company in the open market. This method has advantage over Book Value as it takes
into consideration proper valuation and generally it is slightly higher than Net Realizable Va lue as

quick asset disposal is not encouraged. And due to this reason many author believes that it is the
maximum price that an acquirer would pay for the equivalent business. However, this approach
also suffers from limitation that hard assets are taken into consideration still loyalty of the staff
cannot be taken into consideration.
Conclusions: The asset-based approach can depict the enterprise’s net worth fairly correctly
using the fundamental principle of ‘going concern’. However, it suffers from a major drawback – It
fails to consider the ability of the enterprise to generate future revenues and how the market
dynamics will affect the future operations and cash flow.
3.2 Income based Approach
This approach looks to overcome the drawbacks of using the asset-backed valuation approach by
referring to the earning potential. This method is more suitable when acquiring company is
intending to continue business of target company for foreseen future without selling or liquidating
assets of the same. Accordingly, if there is any additional earning is there due to acquisition same
should also be considered in valuation. Basically, PE Ratio also called Earning Yield is used in this
approach. Though there is another version of the same is Capitalization Rate.
Now let us discuss valuation by these two versions one by one.
3.2.1 PE Ratio or Earning Yield Multiplier
This method is generally used for valuing listed companies whose PE Ratios are available. This
approach has one benefit that it takes into account the expected growth rate of the company as
well as market expectations.
The price or value of equity share can be calculated using the following equation:
Price Per Share = EPS x PE Ratio
Though mainly this method is followed for listed companies but PE Ratio of equivalent companies
or the industry can be used to value the shares of the unlisted companies. This method serves as
minimum acceptable price to the shareholders of the target company. It involves following steps:
(i) Choosing PE Ratio of equivalent quoted company.
(ii) Making adjustment downward for additional risk due to non listing of shares.
(iii) Determination of future maintainable EPS.
(iv) Multiply same EPS with adjusted PE Ratio.
3.2.2 Capitalisation of Earning
In this method the value of business is calculated by capitalization of company’s expected annual
maintainable profit using appropriate required rate of return or yield or discounting rate.
Annual expected maintainable profit can be calculated using weighted average of previous years’
profits after adjusting synergy benefits or economy of scales in the same profit.

The capitalization rate depends on many factors. The capitalization rate can be approximated as
follows:
EPS
Required Earning Yield =
SharePrice
Or
1
Reciprocal of PE Ratio =
PE Ratio
Using this method valuation of the company can be computed as follows:
Expected Annual Maintainable Profit
Capitalized Earning Value =
Capitalization Rate or Required Earning Yield
Though the main advantage of using this method is that it is forward looking approach howe ver the
disadvantages are estimation of expected future profit and difference in treatment of extra ordinary
and exceptional items.
3.3 Cash flow based approach
As opposed to the asset based and income based approaches, the cash flow approach takes into
account the quantum of free cash that is available in future periods, and discounting the same
appropriately to match to the flow’s risk. Variant of this approach in context of equity has been
discussed earlier in the chapter of Security Valuation.
Simply speaking, if the present value arrived post application of the discount rate is more than the
current cost of investment, the valuation of the enterprise is attractive to both stakeholders as well
as externally interested parties (like stock analysts). It attempts to overcome the problem of over-
reliance on historical data as seen in both the previous methods. There are essentially five steps in
performing DCF based valuation:
(a) Arriving at the ‘Free Cash Flows’
(b) Forecasting of future cash flows (also called projected future cash flows)
(c) Determining the discount rate based on the cost of capital
(d) Finding out the Terminal Value (TV) of the enterprise
(e) Finding out the present values of both the free cash flows and the TV, and interpretation of
the results.

Let’s take an example, with assumed figures, to understand how the DCF method works:
Step a:
INR ('000s)
Computation of free cash flows 2016-17 Remarks
EAT (Earning After Taxes) 600
One time events to be
Less: One time incomes (200) eliminated
One time events to be
Add: One time expenses 100 eliminated
Add: Depreciation 100 Depreciation is a book entry
Free Cash Flow 600
Step b:
Assumptions to arrive at Adjusted Free Cash Flow as below:
Free Cash Flow estimated to grow @ 5% p.a.
Suitable assumptions to be made for changes in WC and investments in FA
Projected (in INR '000s)
2017-18 2018-19 2019-20
Free Cash Flow (5 % increment Y-o-Y) 600.00 630.00 661.50
Less: Changes in Working Capital Cycle (50.00) (30.00) 10.00
Less: Investment in Fixed assets (50.00) (50.00) (20.00)
Adjusted Free Cash Flow 500.00 550.00 651.50
Step c:
Discounted Cash Flows (in INR '000s)
2017-18 2018-19 2019-20
WACC (assumed) 8% 8% 8%
PVF 0.926 0.857 0.794
Present Value of Cash flow 463.00 471.35 517.29
Step d:
Terminal Value: The perpetual growth that will be achieved after year 3 onwards is assumed @ 3%
Therefore, TV = (CF at Year 3 * growth rate) / (WACC - growth rate) = (517.29*1.03)/(0.08 - 0.03)
= 10656.17

Step e:
Total DCF of enterprise = 12,107.81 thousands (PV of cash flows arrived in above table plus the
TV arrived)
In other words, the value of the enterprise for a potential acquisition is approximately 12108
thousands.
The DCF is indeed a revolutionary model for valuation as FCFs truly represen t the intrinsic value
of an entity. However, the whole calculation gravitates heavily on the WACC and the TV. In fact in
many cases the TV is found to be a significant portion in final value arrived by DCF. This means
that the growth rate and underlying assumptions need to be thoroughly validated to deny any room
for margin of error of judgment.
4. MEASURING COST OF EQUITY

4.1 Capital Assets Pricing Model (CAPM)
An alternative way to look at value of an investment or a portfolio is to view returns as a direct
benefit of assuming risks. As discussed earlier the CAPM model is represented by the below
formula:
R = rf + β (rm- rf)
Where R = expected rate of return
rf = risk free rate of return
β = Beta value of the stock
Rm = market rate of return
4.2 Arbitrage Pricing Model
It is obvious that the CAPM has gained massive popularity due to its ‘intuitive based approach’ of
classifying risks into 2 buckets – ‘a risk free part’ and ‘the risk part that is relative to the market
index’. However, this is also its greatest inherent weakness - the oversimplification of risks.
In the 1970’s Mr. Stephen Alan Ross, professor and economist, introduced the concept of ‘multiple
factors’ that can influence the risk component – motley of ‘macro-economic factors’. So, the basic
idea is to breakdown risks into individual identifiable elements that influence the overall risk in a
proportion (called ‘factor’), and each factor gets assigned its own beta; and the sum total of all the
assets’ ‘sensitivities’ to ‘n’ factors will give the ‘expected rate of return for the asset’.
In a simplistic way, if a particular asset, say a stock, has its major influencers as the ‘interest rate
fluctuations’ and the ‘sectoral growth rate’, then the stocks’ return would be calculated by using the
Arbitrage Pricing Theory (APT) in the following manner:

(a) Calculate the risk premium for both these two risk factors (beta for the risk factor 1 –
interest rate, and beta of the risk factor 2 – sector growth rate; and,
(b) Adding the risk free rate of return.
Thus, the formula for APT is represented as –
Rf+ β1(RP1) + β2(RP2) + ….βj(RPn)
It is thereby clear that APT strives to model E(R) as ‘a linear function of various macro-economic
factors’ where sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. Note that the APT by itself doesn’t provide for the macro-economic factors that will be
needed to be tested for its sensitivity – however these have to be judicially developed by the
financial analysts keeping in mind the economy they are put in.
4.3 Estimating Beta and Valuation of Unlisted Companies
You would have by this time realized the fact that ‘information’ holds the key to a successful
valuation of an enterprise. The above valuation approaches we have seen viz. asset based,
earnings based and cash flow based, can be applied freely for publicly traded companies where
key information as regards to earnings, assets employed, and board’s opinion on future potential
and growth areas are readily available. Already, audited financial statements are widely used by
financial analysts for various fund and brokerage houses to prepare their ‘review scorecards’ that
will help the investor to decide whether to hold or sell the scripts on the trade bourses.
However, in a developing economy like India, where there are many privately held firms into e-
retail, service management, hospitality, and such other sunrise sectors that are holding out a lot of
promise and are increasingly getting attention as ‘dark horse’ by venture capitalists, angel
investors etc.; the moot question is how to value these entities in the absence of publicly available
information? There are many a time that the directors of these companies do approach CAs for
getting a ‘valuation’ done. The qualified accountant in private companies will also be involved in
the valuation process. What needs to be appreciated is that valuation is indeed an onerous task,
but if meticulously approached, can yield many dividends.
The biggest challenge in calculation of the ‘value’ of a privately held enterprise is arriving at the
Cost of Capital which in turn depends on Beta for the private firm. We have to keep in mind that
most of the publicly listed companies have leveraged capital, whereas the privately owned firms
may not have either zero or insignificant amounts of debt. However, the strategic investor looking
for stake would always like to grow it further on leveraged funds going forward. In fact this is the
precisely the way forward – to raise funds thru corporate bonds and debt instruments but as on the
valuation date, the fact remains that the beta will have to reflect the ‘unleveraged’ posi tion, and
hence, we would use the ‘unlevered beta’, as opposed to levered beta.
Further this problem can also be faced in case of even an existing listed company whi ch decides
to invest in brand new line of business for it. In such situation company should not use its WACC
to evaluate this project. Instead of that it should assess the WACC for the appropriate risk level.

For this the company needs Asset Beta or Ungeared Beta, which needs to be adjusted according
to own gearing level. The Asset Beta represents only systematic risk of the underlying project or
asset of the company and it does not represents any financial risk.
In other words it can be said that Asset Beta represents only company’s business risk. Applying
similar logic of calculation of WACC, the Asset Beta of the company can be calculated using
following equation.
 E   D(1- t) 
βa =β e   + βd  
 E+ D(1- t)   E+ D(1- t) 
βa = Ungeared or Asset Beta
βe = Geared or Equity Beta
βd = Debt Beta
E = Equity
D = Debt
t = Tax Rate
From the above equation it can be seen that company’s Equity Beta shall always be greater than
Asset Beta. In case company is debt free then Equity Beta shall be equal to Asset Beta.
Generally it is assumed that the Debt Beta tends to be Zero as Bonds ’ Returns are not linked to
the volatility of market portfolio. In such situation the above mentioned equation shall become:
 E 
βa =β e  
 E+ D(1- t) 
Thus, if we have been provided with figures of βe of a company we can calculate β a, which shall be
common for the industry or Pure Play firm.
Now let us see what steps are exactly involved in computation of Equity Beta for a new of business
or project for the company.
Step 1: Identify the Pure Play firms or companies (engaged entirely in same business and also
called proxy companies) and their Equity Betas to surrogate the Equity Beta of new Project or
business.
Step 2: Once Beta of proxy companies have been identified we de-gear it and compute the Asset
Beta as the different companies may have different gearing levels.
Step 3: In case if there is only one proxy company then Asset Beta of the same company shall be
continued for further analysis. In case there are more than one proxy companies then we sha ll
take average of Asset Betas of these companies. Otherwise we can also opt for the Asset Beta of
the company that appears to be most appropriate.

Step 4: In next step we must re-gear the Asset Beta as per capital structure of the appraising
company to reflect the financial risk using the following formula (changing the positions of Asset
Beta mentioned earlier)
 E+ D(1- t) 
βe =β a  
 E 
Step 5: In this step we can insert computed βe in CAPM and can compute required rate of return
for project under consideration or value of the business.
Illustration 1
There is a privately held company X Pvt. Ltd that is operating into the retail space, and is now
scouting for angel investors. The details pertinent to valuing X Pvt. Ltd are as follows –
The company has achieved break even this year and has an EBITDA of 90. The unleveraged beta
based on the industry in which it operates is 1.8, and the average debt to equity ratio is hovering at
40:60. The rate of return provided by risk free liquid bonds is 5%. The EV is to be taken at a
multiple of 5 on EBITDA. The accountant has informed that the EBITDA of 90 includes an
extraordinary gain of 10 for the year, and a potential write off of preliminary sales promotion costs
of 20 are still pending. The internal assessment of rate of market return for the industry is 11%.
The FCFs for the next 3 years are as follows:
Y1 Y2 Y3
Future Cash flows 100 120 150
The pre-tax cost of debt is 12%. Assume a tax regime of 30%.

What is the potential value to be placed on X Pvt. Ltd?
Solution
The levered beta of the company will be 1.8[1+(1-0.3)*40/60)] = 2.64
The adjusted EBITDA would be 90 –10 – 20 = 60
The EV will be multiple of 5 on the 60 obtained above = 300
The Cost of equity in accordance with CAPM = r (f) + β (Rm – Rf)
= 5% + 2.64 (11% - 5%) = 20.84%
The WACC = Cost of Equity + Cost of Debt
= 20.84 (60/100) + 12.0 (1-0.3) (40/100) = 15.864

Finally, the future cash flows can be discounted at the WACC obtained above as under –
Y1 Y2 Y3
Future Cash flows 100 120 150
Discount factor 0.863 0.745 0.643
PVs of cash flows 86.30 89.40 96.45
VALUE OF THE FIRM 272.15
5. RELATIVE VALUATION
The three approaches that we saw to arriving at the value of an enterprise viz. the asset based,
the earnings based and the cash flow based are for arriving at the ‘intrinsic value’ of the same.
Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis to its
peers or similar enterprises. However, increasingly the contemporary financial analysts are using
relative valuation in conjunction to the afore-stated approaches to validate the intrinsic value
arrived earlier.
The Concept of ‘Relative Valuation’: One way to look at the practical implementation of fair value
within the valuation context would be to identify assets that are similar to the ones held by the
acquiree company so that the values can be compared. This would be a significant departure from
the ‘intrinsic value’ approach that we have seen until now. Trying to get a value that would be the
nearest to the market price would mean that the valuation of a particular portfolio, or a divestiture
in an entity, would happen at an agreeable price that fits into the normal distribution.
In one sense, we are indeed using the relative valuation in a limited approach when we speak
about expected market returns, or when we are adopting an index based comparative. The more
the asset pricing gets correlated to the similar assets in the market, the more inclusive it gets.
Thus, when we are comparing bonds, the closer the YTM of the bond to the government index of
return, the more credible it gets when it comes to pricing.
The Relative valuation, also referred to as ‘Valuation by multiples,’ uses financial ratios to derive at
the desired metric (referred to as the ‘multiple’) and then compares the sam e to that of comparable
firms. Comparable firms would mean the ones having similar asset and risk dispositions and
assumed to continue to do so over the comparison period. In the process, there may be
extrapolations set to the desired range to achieve the target set. To elaborate –
1. Find out the ‘drivers’ that will be the best representative for deriving at the multiple
2. Determine the results based on the chosen driver(s) through financial ratios
3. Find out the comparable firms, and perform the comparative analysis, and,
4. Iterate the value of the firm obtained to smoothen out the deviations

Step 1: Finding the correct driver that goes to determine the multiple is significant for relative
valuation as it sets the direction to the valuation approach. Thereby, one can have two sets of
multiple based approaches depending on the types of the drivers –
(a) Enterprise value based multiples, which would consist primarily of EV/EBITDA, EV/Invested
Capital and EV/Sales.
(b) Equity value based multiples, which would comprise of P/E ratio and Price Earning Growth
(PEG) Ratio.
We have already seen the concept and application of Enterprise Value in previous section.
However, in light of relative valuation, we can definitely add that whereas EV/EBITDA is a popular
ratio and does provide critical inputs, the EV/Invested Capital will be more appropriate to capital
intensive enterprises, and EV/Sales will be used by companies who are cash rich, have a huge
order book, and forecast organic growth through own capital.
The P/E has a celebrated status amongst Equity based multiples, and t he PEG (PE Ratio/ Growth
Rate i.e. the ratio of the PE to the expected growth rate of the firm) is more suitable where we are
doing relative valuation of either high growth or sunrise industries.
Step 2: Choosing the right financial ratio is a vital part of success of this model. A factor based
approach may help in getting this correct – for example – a firm that generates revenue mostly by
exports will be highly influenced by future foreign exchange fluctuations. A pure P/E based ratio
may not be reflective of this reality, which couldn’t pre-empt the impacts that Brexit triggered on
currency values. Likewise, an EV/Invested Capital would be a misfit for a company which may be
light on core assets, or if has significant investment properties.
Step 3: Arriving at the right mix of comparable firms. This is perhaps the most challenging of all
the steps – No two entities can be same – even if they may seem to be operating within the same
risk and opportunity perimeter. So, a software company ‘X’ that we are now comparing to a similar
sized company ‘Y’ may have a similar capital structure, a similar operative environment, and head
count size – so far the two firms are on even platform for returns forecast and beta values. On
careful scrutiny, it may be realized that the revenue generators are different – X may be deriving
its revenues from dedicated service contracts having Full Time Equivalent (FTE) pricing, whereas
Y earns through Unit Transfer Pricing (UTP) model. This additional set of information dramatically
changes the risk structure – and this is precisely what the discerning investor has to watch for. In
other words, take benchmarks with a pinch of salt.
Take another example – a firm is operating in a niche market, and that obviously leads to getting
comparable firms become a difficult task. In such cases, one may have to look beyond the current
operating market and identify similar structured companies from other industries.
The comparable firm can either be from a peer group operating within the same ris ks and
opportunities perimeter, or alternatively can be just take closely relevant firms and then perform a
regression to arrive at the comparable metrics. You would notice that in our example, the analyst

is adopting the later approach. Whereas the company ‘X’ will have to ignore ‘Y’ and search for a
similar revenue-risk based company. However, as a last resort, it may adopt a regression based
model as above.
Step 4: Iterate / extrapolate the results obtained to arrive at the correct estimate of the value of the
firm.
Thus, we can conclude that ‘Relative Valuation’ is a comparative driven approach that assumes
that the value of similar firms can form a good indicator for the value of the tested firm. There are
some assumptions that are inherent to this model –
i. The market is efficient
ii. The function between the fundamentals and the multiples are linear
iii. The firms that are comparable are similar to structure, risk and growth pattern
Further, we can approach Enterprise Value (EV) in two ways –
(a) Take Entity Value as the base, and then adjust for debt values for arriving the ‘EV’;
or
(b) Take a balance sheet based approach and arrive at EV.
Let’s apply the above concepts into a relative valuation illustration:
Illustration 2
A Ltd. made a Gross Profit of ` 10,00,000 and incurred Indirect Expenses of ` 4,00,000. The
number of issued Equity Shares is 1,00,000. The company has a Debt of ` 3,00,000 and Reserves
& Surplus to the tune of ` 5,00,000. The market related details are as follows:
Risk Free Rate of Return 4.5%
Market Rate of Return 12%
β of the Company 0.9
Determine:
(a) Per Share Earning Value of the Company.
(b) Equity Value of the company if applicable EBITDA multiple is 5.
Solution
(a) Capitalization Rate using CAPM
4.5% + 0.9(12% - 4.5%) = 11.25%

Calculation of Earning Value Per Share

(` 000)
Gross Profit 1000
Less: Indirect Expenses (400)
EBITDA 600
Earning Value of Company (600/ 0.1125) 5333.33
Number of Shares 1,00,000
Earning Value Per Share ` 53.33
(b) Equity Value of Company

(` 000)
EBITDA 600
EBITDA Multiple 5
Capitalized Value 3000
Less: Debt (300)
Add: Surplus Funds 500
Equity Value (Enterprise Value) 3200
Now let us see how EV can be arrived at using Balance Sheet approach in the following
illustration.
Illustration 3
The balance sheet of H K Ltd. is as follows:
` 000
Non-Current Assets 1000
Current Assets
Trade Receivables 500
Cash and cash equivalents 500
2000
Shareholders' funds 800

Long Term Debt 200
Current Liabilities and Provisions 1000
2000
The shares are actively traded and the Current Market Price (CMP) is ` 12 per share. Shareholder
funds represent 70,000 shares of ` 10 each and rest is retained earnings. Calculate the Enterprise
Value of HK Ltd.

Solution
Shares outstanding 70,000
CMP ` 12
Market Capitalization ` 8,40,000
Add: Debt ` 2,00,000
Less: Cash & Cash equivalents (` 5,00,000)
Enterprise Value (EV) ` 5 40 000
6. OTHER APPROACHES TO VALUE MEASUREMENT

6.1 Contemporary Approaches to Valuation
With businesses become exceedingly technology driven and managements now trying to position
themselves as ‘value creators’ thereby venturing into a ‘conglomerate’ way of thinking and running
business, the concept of value and valuation has also undergone a paradigm shift. T he tag for
‘MNC’ and inorganic growth has given rise to complex structures and tiers of management styles
and business houses. Of course, the more discerning of the lot would still stick to the original
game-plan as has been ruminated by us in the sections of this guide till now – separate the seed
from the chaff - by using the time honored ‘asset’ based, or ‘income’ based approaches or by
adopting a more mature ‘cash flow’ based one; and even a meticulous combination of all the three;
but it’s not common to find the bull market referring to, and analysts liberally using terminologies
like the ‘PEs’ and ‘Exit Multiples’, and to ‘LBOs’ and ‘Brand Value’.
It is worth noting here that some of these concepts used in valuation have been borne out of the
peculiarities of certain industries. An internet company would have virtually zero fixed assets – but
a robust online presence and a huge brand recall value. This would give rise to a new method of
valuation – Price Per Page visited. Or an online play store can be valued now using ‘Price Per
Subscriber’. However, like previously referred, the more discerning would still like to ask for the
cash to sales ratio, apply a DCF model before they put the money in the pot.
Another contemporary way to value a company is to have ‘Goodwill’ based approach – a retail
giant looking to desperately acquire a traditional mom-pop store in a particular hotspot that is
giving a run for its money could rightfully adopt this method – firstly take an asset based valuation,
and then value for the goodwill separately by linking a multiple to its annual sales or its footfall.
Price Earning Ratio (PER) - It equates the EPS (Earnings Per Share) to the price prevailing on
the stock market – the logic being that the market prices the stock based on its fundamentals, and
as a corollary you don’t have to look beyond the same to value the stock! So, assume the EPS of a
company is ` 40, and the average share price over the last quarter is ` 50, the PER would be
50/40 which works to 1.25. But we need to understand the important fact that PER is a relative

figure, and comparison across industries in the same sector can give a more median PER that
may be acceptable for valuation purposes.
LBOs (Leveraged Buy Outs) – The increasing complex nature of commerce and its applications
have given rise to a new category of ‘strategic investors’ – Private Equity (PE) firms who scout for
enterprises in the ‘rough’, acquire the same using a clever mix of debt and equity (typically at
70:30 debt to equity), and then targeting to sell the same within a medium term period, say 3 to 5
years. In the process, they leverage on the debt and create value (both perceived and real) , and
then they either spin off the management control to another entity for a price, or go for a n outright
sale.
Example
X is a small software company that is providing a niche data control and testing service having 60
employees and some steady contracts, which generates an EBIDTA of ` 100 Lacs per year. A
Venture Capitalist (VC) convinces the managing director of the company to sell off the majority
stake to him – valued at a premium of 100% per share over the Book Value plus one time goodwill
payoff of ` 50 Lacs, using an Income Based Valuation approach. Thus the total consideration
comes out ` 250 Lacs.
Next, the VC ropes a banker to pump in ` 200 Lacs for the acquisition-cum-expansion as well as
to do brand marketing, thereby making the company a visible player in the market. The gap of ` 50
Lacs is his contribution as promoter equity towards securities premium. Since the core operations
team is not dismantled, the company easily achieves a 20% average growth in each of the next 3
years.
At the end of the third year, the VC puts the company on the ‘Sale Block’ and is able to garner
interest of a leading MNC in the same. Assume if the exit multiple that the VC looks is at 7 times
the EBDAT. The entity value is hypothetically can be worked out as under –
(in ` Lacs)
Y0 Y1 Y2 Y3
EBIDTA 100.00 120.00 144.00 178.00
Less: Interest# 36.00 30.00 24.00 18.00
EBDTA 64.00 90.00 120.00 160.00
Less: Taxes @ 30% 19.20 27.00 36.00 48.00
EBDAT 44.80 63.00 84.00 112.00
Multiple 7
Capitalized Value at end of Y 3 784
Less: Debt (100)
Equity Value 684
# Debt principal assumed to be repayable linearly in 6 years.

One of the prime casualties in a LBO model is that the future cannot be predicted with e xactitude.
Thus, if at end of third year, the industry is caught in a cyclical slowdown, the VC will find itself
saddled with a huge loan and burgeoning interest costs difficult to recycle.
6.2 Chop-Shop Method
This approach attempts to identify multi-industry companies that are undervalued and would have
more value if separated from each other. In other words as per this approach an attempt is made
to buy assets below their replacement value. This approach involves following three steps :
Step 1: Identify the firm’s various business segments and calculate the average capitalization
ratios for firms in those industries.
Step 2: Calculate a “theoretical” market value based upon each of the average capitalization
ratios.
Step 3: Average the “theoretical” market values to determine the “chop-shop” value of the firm.
Illustration 4
Using the chop-shop approach (or Break-up value approach), assign a value for Cornett GMBH.
whose stock is currently trading at a total market price of €4 million. For Cornett, the accounting
data set forth in three business segments: consumer wholesaling, specialty services, and assorted
centers. Data for the firm’s three segments are as follows:
Business segment Segment sales Segment assets Segment income
Consumer wholesaling €1,500,000 € 750,000 €100,000
Specialty services €800,000 €700,000 €150,000
Assorted centers €2,000,000 €3,000,000 €600,000
Industry data for “pure-play” firms have been compiled and are summarized as follows:
Business segment Capitalization/ Capitalization/ Capitalization/
sales assets operating income
Consumer wholesaling 0.75 0.60 10.00
Specialty services 1.10 0.90 7.00
Assorted centers 1.00 0.60 6.00
Solution
Cornett, GMBH. – Break-up valuation
Business Segment Capital-to-Sales Segment Sales Theoretical Values
Consumer wholesaling 0.75 €1,500,000 €1,125,000
Specialty services 1.10 €800,000 €880,000
Assorted centers 1.00 €2,000,000 €2,000,000
Total value €4,005,000


Consumer wholesaling 0.60 €750,000 €450,000
Specialty services 0.90 €700,000 €630,000
Assorted centers 0.60 €3,000,000 €1,800,000

Consumer wholesaling 10.00 €100,000 €1,000,000
Specialty services 7.00 €150,000 €1,050,000
Assorted centers 6.00 €600,000 €3,600,000
4,005,000+ 2,880,000+ 5,650,000

Average theoretical value = = 4,178,333.33 say 4,178,000
3
Average theoretical value of Cornett GMBH. = €4,178,000
6.3 Economic Value Added (EVA)

Economic Value Added (EVA) is a holistic method of evaluating a company’s financial
performance, which means that EVA is used not only as a mere valuation technique, but also to
find the economic contribution of a company to the society at large. The core concept behind EVA
is that a company generates ‘value’ only if there is a creation of wealth in terms of returns in
excess of its cost of capital invested. EVA insists on separation of firm’s operation from its
financing. So if a company's EVA is negative, it means the company is not generating value from
the funds invested into the business. Conversely, a positive EVA shows a company is producing
value from the funds invested in it.
Why EVA? Up to now we have seen several financial performance metrics like ROI, ROCE, etc.
and also several approaches based on asset base / earnings / FCFs to finding out the ‘worth’ of
the entity. Then what is the need for EVA? Or in other words, what is the gap that EVA is trying to
fill in, that others couldn’t?
The answer to the above is the way EVA looks at performance of the ‘management’ of a company.
To elaborate, all the approaches seen up to now were just a function of ‘number-crunching’. But
EVA tries to make management more accountable to their individual decisions and the impact of
decisions on the path to progress of the company. Take a simple example – if there are two
dissimilar but equal risk opportunities that are feasible and the management needs to take a
decision, it would most probably go by the project which would break-even earlier. In choosing so
it is also cutting down the risk of future losses, fair enough. However, had the management
invested in both the projects, still it would have generated a positive IRR, though the second one
would have had a larger pay-back period. This impact of management’s strategic decision making

comes out evidently in EVA computations, whereas under the techniques seen till now, this
performance-driven aspect would have never been highlighted. The efficiency of the management
gets highlighted in EVA, by evaluating whether returns are generated to cover the cost of capital.
EVA is a performance measure for management of the company, and this is as evident in its
calculation formula as ‘the excess of returns over the weighted average cost of invested capital ‘.
The formula is as below –
EVA = NOPAT – (Invested Capital * WACC)
OR
NOPAT – Capital Charge
The concept NOPAT (Net Operating Profit After Tax) is nothing but EBIT minus tax expense. The
logic is that we are trying to find out the cash returns that business operations would make a fter
tax payments. Note that we have left depreciation untouched here – it being an operational
expense for the limited purposes of EVA. From this NOPAT we need to further identify the non-
cash expenses and adjust for the same to arrive at the ‘actual’ cash earnings. One common non-
cash adjustment would ‘provision for bad and doubtful debts’, as this would just be a book entry.
After arriving at the correct NOPAT, the next step would be finding the capital charge. This would
involve finding out
(a) Invested Capital – Which would be easy from published financials, as it would be the
difference between total assets subtracted by the non-interest bearing current liabilities, like
sundry creditors, billing in advance, etc. Care should be taken to do the adjustments for
non-cash elements like provision for bad and doubtful debts. Also it means equity plus long
term debt and generally at the start of the year. Further some changes or adjustment are
needed to be made on account of Non Cash Expenses both in Invested Capital and
NOPAT.
(b) Applying the company’s WACC on the invested capital arrived in step (a)
Finally the EVA is computed by reducing the capital charge as calculated by applying the WACC
on the invested capital from the adjusted NOPAT.
Illustration 5
Compute EVA of A Ltd. with the following information:
All Figure are in ` Lac
Profit and Loss Statement Balance Sheet
Revenue 1000 PPE 1000
Direct Costs -390 Current Assets 300
Selling, General &
Admin. Exp. (SGA) -200 1300

EBIT 410 Equity 700

Interest -10 Reserves 100
EBT 400 Non-Current Borrowings 100
Tax Expense -120 Current Liabilities & Provisions 400
EAT 280 1300
Assume Bad Debts provision of ` 20 Lac is included in the SGA, and same amount is reduced
from the trade receivables in current assets.
Also assume that the pre-tax Cost of Debt is 12%, Tax Rate is 30% and Cost of Equity (i.e.
shareholder’s expected return) is 8.45%.
Solution
Step I: Computation of NOPAT
NOPAT
EBIT 410
Less: Taxes -123
Add: Non-Cash Expenses 20
NOPAT 307
Step II: Finding out the Invested Capital:

Invested Capital
Total Assets 1300
Less: Non Interest bearing liabilities -400
900
Add: Non Cash adjustment 20
920
Note: It is assumed that the current liabilities also include the 100 of tax liab ility.
Step III: Compute the WACC
WACC = Cost of equity + Cost of debt
In this case, WACC = (800/900*8.45%) + [100/900*12% (1 - 0.30)] = 8.44%
Step IV: Find out the Capital Charge
Capital Charge = Invested Capital * WACC = 920 * 8.44% = 77.65
Step V: EVA = Adjusted NOPAT – Capital Charge = 307 – 77.65 = 229.35

6.4 Market Value Added (MVA)

The ‘MVA’ (Market Value Added) simply means the Current Market Value of the firm minus the
Invested Capital that we obtained above. Let the current MV of the firm be 1000. Hence MVA will
be –
1000 – 920 = 80.
MVA is an attempt to resolve some of the issues involved in EVA e.g. ignoring Value Drivers, Book
Value etc. Though MVA itself does not give any basis of share valuation but an alternative way to
gauge performance efficiencies of an enterprise, albeit from a market capitalization point of view,
the logic being that the market will discount the efforts taken by the management fairly. Hence, the
MVA of 80 arrived in example above is the true value added that is perceived by the market. In
contrast, EVA is a derived value added that is for the more discerning investor.
Since MVA represents market views regarding company’s future value generation c ompanies with
a higher MVA will naturally become the darlings of the share market, and would eventually become
‘pricey’ from a pure pricing perspective. In such cases, the EVA may also sometimes have a
slightly negative correlation as compared to MVA. But this will be a short term phenomenon as
eventually the gap will get closed by investors themselves. A stock going ex-dividend will exhibit
such propensities.
We can conclude that the main objective of EVA is thus to show management efficiency in
generating returns over and above the hurdle rate of invested capital.
6.5 Shareholder Value Analysis (SVA)
Now that we have seen ‘EVA’ and ‘MVA’, let’s proceed to see the concept of ‘SVA’ but questions
first – why SVA? And how does SVA behave?
We understand that the EVA is the residual that remains if the ‘capital charge’ is subtracted from
the NOPAT. The ‘residual’ if positive simply states that the profits earned are adequate to cover
the cost of capital.
However, is NOPAT the only factor that affects shareholder’s wealth? The answer is not a strict
‘no’, but definitely it is ‘inadequate’, as it doesn’t take future earnings and cash flows into account.
In other words, NOPAT is a historical figure, albeit a good one though, but cannot fully represent
for the future potencies of the entity. More importantly, it doesn’t capture the future in vestment
opportunities (or the opportunity costs, whichever way you look). SVA looks to plug in this gap by
tweaking the value analysis to take into its foray certain ‘drivers’ that can expand the horizon of
value creation. The key drivers considered are of ‘earnings potential in terms of sales, investment
opportunities, and cost of incremental capital.
The following are the steps involved in SVA computation:
(a) Arrive at the Future Cash Flows (FCFs) by using a judicious mix of the ‘value drivers’ as
discussed earlier

(b) Discount these FCFs using the WACC

(c) Add the terminal value to the present values computed in step (b)
(d) Current market value of non-core assets and marketable investment.
(e) Reduce the value of debt from the result in step (d) to arrive at value of eq uity.
Let’s take a progressive case study to run through the SVA calculations:
Step a.1: Using the appropriate value drivers, arrive at the operating cash flows:
(in $ Millions)
Y1 Y2 Y3 Y4 onwards
EBIT (growing at 5% yearly) 100.00 105.00 110.25 115.76
Interest Cost 5.00 6.00 7.00 8.00
EBT 95.00 99.00 103.25 107.76
Taxes @ 33% 31.35 32.67 34.07 35.56
EAT 63.65 66.33 69.18 72.20
Add back : Depreciation 5.00 5.00 6.00 7.00
Add back : One time write
offs 1.00 - - -
Operating Cash Flow 69.65 71.33 75.18 79.20
Step a(2):
Operating Cash Flow 69.65 71.33 75.18 79.20
Less: Forecasted Incremental Capital Invest. -- 12.00 6.00 9.00
Less: Forecasted Net Working Capital 5.00 5.00 6.00 7.00
Free Cash Flow (FCFs) 64.65 54.33 63.18 63.20
Step b: Applying the WACC to find out the discounted values:

Free Cash Flow (FCFs) 64.65 54.33 63.18 63.20
WACC (discount rate) @ 12% 0.89 0.80 0.71 0.64
Present Value of FCFs 57.54 43.46 44.86 40.45
Step c: Finding out the proper TV:

Multiplier for TV (1 ÷ 0.12) 8.33

Step d & e:
Total PVs 482.81
Add: Investment Property (at FV) 35.00
Less: Carrying cost of Debt (19.00)
Value of Equity 498.81
Thus, we observe that SVA brings out a futuristic sense of value for shareholders. In fact, this can
be a good benchmark for shareholders from a cash return on investment perspective too.
7. ARRIVING AT FAIR VALUE

The ultimate purpose of a potential acquirer of the controlling stake and / or the takeover of a
company is that ‘he would purchase the same at the fair price – no less no more’.
In fact, the approaches to valuation seen in this chapter along with the different methods of
performing a value added analysis is to identify entities that are ‘attractive’ in terms of the true
value to a potential investor.
A Chartered Accountant’s perspective to ‘fair value’ would automatically envisage a transaction to
be measured at the arm’s length. For a financial analyst, the term would be akin to the present
value of an entity in cash terms, and for a speculative investor, the term would represent the
arbitrage opportunities that open up among similar entities having dissimilar value numbers put to
it.
However, it’s an undeniable fact that in an upward boom time, the valuations defy fair value, for
example, the dot com boom had companies getting valued for astronomical sums. And when the
downturn arrived, some of these companies vanished and others were just able to stand up their
ground.
In this chapter we have discussed various methods of valuation. Though they have their own pros
and cons but it depends on the vision of the ultimate decision maker which method is suitable for
his/ her purpose. Further it can be said that there is no single answer to method of valuation as
correct one and it will be better if a range of values i.e. minimum acceptable by seller and
maximum payable by the buyer could be determined. Ultimately the final deal would depend on the
negotiation among the parties.
Accordingly, following approaches can be adopted to solve the question especially involving
evaluation and synthesis skill assessment requirements.
(i) Unless specified otherwise calculate valuation by as many as possible with available data.
(ii) Give comments on the valuation by each of these methods.
(iii) Supplement your conclusion with any additional information if available.

CASE STUDIES
A couple of real life case studies would help us to understand the Concepts better –
Case Study 1
The application of ‘valuation’ in the context of the merger of Vodafone with Idea Cell ular
Ltd:
The valuation methods deployed by the appointed CA firms for the merger were as follows:
(a) Market Value method: The share price observed on NSE (National Stock Exchange) for a
suitable time frame has been considered to arrive at the valuation.
(b) Comparable companies’ market multiple method: The stock market valuations of
comparable companies on the BSE and NSE were taken into account.
(c) NAV method: The asset based approach was undertaken to arrive at the net asset value of
the merging entities as of 31st December 2016.
Surprisingly, the DCF method was not used for valuation purposes. The reason stated was that the
managements to both Vodafone and Idea had not provided the projected (future) cash flows and
other parameters necessary for performing a DCF based valuation.
The final valuation done using methods a to c gave a basis to form a merger based on the ‘Share
Exchange’ method.
Above information extracted from: ‘Valuation report’ filed by Idea Cellular with NSE
However, let’s see how the markets have reacted to this news – the following article published in
The Hindu Business Line dated 20th March 2017 will give a fair idea of the same:
“Idea Cellular slumped 9.6 per cent as traders said the implied deal price in a planned merger with
Vodafone PLC's Indian operations under-valued the company shares. Although traders had
initially reacted positively to the news, doubts about Idea's valuations after the merger sent shares
downward.
Idea Cellular Ltd fell as much as 14.57 per cent, reversing earlier gains of 14.25 per cent, after the
telecom services provider said it would merge with Vodafone Plc's Indian operations.”
Hence, we can conclude that the valuation methods, though technically correct, may not elicit a
positive impact amongst stockholders. That is because there is something called as ‘perceiv ed
value’ that’s not quantifiable. It depends upon a majority of factors like analyst interpretations,
majority opinion etc.

Case Study 2
Valuation model for the acquisition of ‘WhatsApp’ by Facebook
Facebook announced the takeover of WhatsApp for a staggering 21.8 billion USD in 2015. The key
characteristics of WhatsApp that influenced the deal were –
(a) It is a free text-messaging service and with a $1 per year service fee, had 450 million users
worldwide close to the valuation date.
(b) 70% of the above users were active users.
(c) An aggressive rate of user account increase of 1 million users a day would lead to pipeline
of 1 billion users just within a year’s range.
The gross per-user value would thus, come to an average of USD 55, which included a 4 billion
payout as a sweetener for retaining WhatsApp employees post takeover. The payback for
Facebook will be eventually to monetize this huge user base with recalibrated charges on
international messaging arena. Facebook believes that the future lies in international, cross-
platform communications.
Above information extracted from the official website of business news agency ‘CNBC’
TEST YOUR KNOWLEDGE

Theoretical Questions
1. Differentiate between EVA and MVA.
2. Relative Valuation is the method to arrive at a ‘relative’ value using a ‘comparative’ analysis
to its peers or similar enterprises. Elaborate this statement.
Practical Questions
1. ABC Company is considering acquisition of XYZ Ltd. which has 1.5 crores shares
outstanding and issued. The market price per share is ` 400 at present. ABC's average
cost of capital is 12%. Available information from XYZ indicates its expected cash accruals
for the next 3 years as follows:
Year ` Cr.
1 250
2 300
3 400
Calculate the range of valuation that ABC has to consider. (PV factors at 12% for years 1 to
3 respectively: 0.893, 0.797 and 0.712).
2. Eagle Ltd. reported a profit of ` 77 lakhs after 30% tax for the financial year 2011-12. An

analysis of the accounts revealed that the income included extraordinary items of ` 8 lakhs
and an extraordinary loss of `10 lakhs. The existing operations, except for the extraordinary
items, are expected to continue in the future. In addition, the results of the launch of a new
product are expected to be as follows:
` In lakhs
Sales 70
Material costs 20
Labour costs 12
Fixed costs 10
You are required to:

(i) Calculate the value of the business, given that the capitalization rate is 14%.
(ii) Determine the market price per equity share, with Eagle Ltd.‘s share capital being
comprised of 1,00,000 13% preference shares of ` 100 each and 50,00,000 equity
shares of ` 10 each and the P/E ratio being 10 times.
3. ABC Co. is considering a new sales strategy that will be valid for the next 4 years. They
want to know the value of the new strategy. Following information relating to the year which
has just ended, is available:
Income Statement `
Sales 20,000
Gross margin (20%) 4,000
Administration, Selling & distribution expense (10%) 2,000
PBT 2,000
Tax (30%) 600
PAT 1,400
Balance Sheet Information
Fixed Assets 8,000
Current Assets 4,000
Equity 12,000
If it adopts the new strategy, sales will grow at the rate of 20% per year for three years.
From 4th year onward it will stabilize. The gross margin ratio, Assets turnover ratio, the
Capital structure and the income tax rate will remain unchanged.
Depreciation would be at 10% of net fixed assets at the beginning of the year.
The Company’s target rate of return is 15%.
Determine the incremental value due to adoption of the strategy.

4. H Ltd. agrees to buy over the business of B Ltd. effective 1 st April, 2012.The summarized
Balance Sheets of H Ltd. and B Ltd. as on 31 st March 2012 are as follows:
Balance sheet as at 31st March, 2012 (In Crores of Rupees)
Liabilities: H. Ltd B. Ltd.
Paid up Share Capital
-Equity Shares of `100 each 350.00
-Equity Shares of `10 each 6.50
Reserve & Surplus 950.00 25.00
Total 1,300.00 31.50
Assets:
Net Fixed Assets 220.00 0.50
Net Current Assets 1,020.00 29.00
Deferred Tax Assets 60.00 2.00
Total 1,300.00 31.50
H Ltd. proposes to buy out B Ltd. and the following information is provided to you as part of
the scheme of buying:
(1) The weighted average post tax maintainable profits of H Ltd. and B Ltd. for the last 4
years are ` 300 crores and ` 10 crores respectively.
(2) Both the companies envisage a capitalization rate of 8%.
(3) H Ltd. has a contingent liability of ` 300 crores as on 31 st March, 2012.
(4) H Ltd. to issue shares of ` 100 each to the shareholders of B Ltd. in terms of the
exchange ratio as arrived on a Fair Value basis. (Please consider weights of 1 and 3
for the value of shares arrived on Net Asset basis and Earnings capitalization
method respectively for both H Ltd. and B Ltd.)
You are required to arrive at the value of the shares of both H Ltd. and B Ltd. under:
(i) Net Asset Value Method
(ii) Earnings Capitalisation Method
(iii) Exchange ratio of shares of H Ltd. to be issued to the shareholders of B Lt d. on a
Fair value basis (taking into consideration the assumption mentioned in point
4 above.)
5. AB Ltd., is planning to acquire and absorb the running business of XY Ltd. The valuation is
to be based on the recommendation of merchant bankers and the consideration is to be
discharged in the form of equity shares to be issued by AB Ltd. As on 31.3.2006, the paid
up capital of AB Ltd. consists of 80 lakhs shares of ` 10 each. The highest and the lowest

market quotation during the last 6 months were ` 570 and ` 430. For the purpose of the
exchange, the price per share is to be reckoned as the average of the highest and lowest
market price during the last 6 months ended on 31.3.06.
XY Ltd.’s Balance Sheet as at 31.3.2006 is summarised below:
` lakhs
Sources
Share Capital
20 lakhs equity shares of `10 each fully paid 200
10 lakhs equity shares of `10 each, `5 paid 50
Loans 100
Total 350
Uses
Fixed Assets (Net) 150
Net Current Assets 200
350
An independent firm of merchant bankers engaged for the negotiation, have produced the
following estimates of cash flows from the business of XY Ltd.:
Year ended By way of ` lakhs
31.3.07 after tax earnings for equity 105
31.3.08 do 120
31.3.09 Do 125
31.3.10 Do 120
31.3.11 Do 100
Terminal Value estimate 200
It is the recommendation of the merchant banker that the business of XY Ltd. may be
valued on the basis of the average of (i) Aggregate of discounted cash flows at 8% and (ii)
Net assets value. Present value factors at 8% for years
1-5: 0.93 0.86 0.79 0.74 0.68
You are required to:
(i) Calculate the total value of the business of XY Ltd.
(ii) The number of shares to be issued by AB Ltd.; and
(iii) The basis of allocation of the shares among the shareholders of XY Ltd.
6. The valuation of Hansel Limited has been done by an investment analyst. Based on an
expected free cash flow of ` 54 lakhs for the following year and an expected growth rate of

9 percent, the analyst has estimated the value of Hansel Limited to be ` 1800 lakhs.
However, he committed a mistake of using the book values of debt and equity.
The book value weights employed by the analyst are not known, but you know that Hansel
Limited has a cost of equity of 20 percent and post tax cost of debt of 10 percent. The value
of equity is thrice its book value, whereas the market value of its debt is nine-tenths of its
book value. What is the correct value of Hansel Ltd?
7. Following information are available in respect of XYZ Ltd. which is expected to grow at a
higher rate for 4 years after which growth rate will stabilize at a lower level:
Base year information:
Revenue - ` 2,000 crores
EBIT - ` 300 crores
Capital expenditure - ` 280 crores
Depreciation - `200 crores
Information for high growth and stable growth period are as follows:
High Growth Stable Growth
Growth in Revenue & EBIT 20% 10%
Growth in capital expenditure and 20% Capital expenditure are
depreciation offset by depreciation
Risk free rate 10% 9%
Equity beta 1.15 1
Market risk premium 6% 5%
Pre tax cost of debt 13% 12.86%
Debt equity ratio 1:1 2:3
For all time, working capital is 25% of revenue and corporate tax rate is 30%.
What is the value of the firm?
8. Following information is given in respect of WXY Ltd., which is expected to grow at a rat e of
20% p.a. for the next three years, after which the growth rate will stabilize at 8% p.a. normal
level, in perpetuity.
For the year ended March 31, 2014
Revenues ` 7,500 Crores
Cost of Goods Sold (COGS) ` 3,000 Crores
Operating Expenses ` 2,250 Crores
Capital Expenditure ` 750 Crores
Depreciation (included in Operating Expenses) ` 600 Crores

During high growth period, revenues & Earnings before Interest & Tax (EBIT) will grow at
20% p.a. and capital expenditure net of depreciation will grow at 15 % p.a. From year 4
onwards, i.e. normal growth period revenues and EBIT will grow at 8% p.a. and incremental
capital expenditure will be offset by the depreciation. During both high growth & normal
growth period, net working capital requirement will be 25% of revenues.
The Weighted Average Cost of Capital (WACC) of WXY Ltd. is 15%.
Corporate Income Tax rate will be 30%.
Required:
Estimate the value of WXY Ltd. using Free Cash Flows to Firm (FCFF) & WACC
methodology.
The PVIF @ 15 % for the three years are as below:
Year t1 t2 t3
PVIF 0.8696 0.7561 0.6575
9. With the help of the following information of Jatayu Limited compute the Economic Value
Added:
Capital Structure Equity capital ` 160 Lakhs
Reserves and Surplus ` 140 lakhs
10% Debentures ` 400 lakhs
Cost of equity 14%
Financial Leverage 1.5 times
Income Tax Rate 30%
10. RST Ltd.’s current financial year's income statement reported its net income after tax as `
25,00,000. The applicable corporate income tax rate is 30%.
Following is the capital structure of RST Ltd. at the end of current financial year:
`
Debt (Coupon rate = 11%) 40 lakhs
Equity (Share Capital + Reserves & Surplus) 125 lakhs
Invested Capital 165 lakhs

Following data is given to estimate cost of equity capital:
Equity Beta of RST Ltd. 1.36

Risk –free rate i.e. current yield on Govt. bonds 8.5%
Average market risk premium (i.e. Excess of return on market portfolio 9%
over risk-free rate)
Required:
(i) Estimate Weighted Average Cost of Capital (WACC) of RST Ltd.; and
(ii) Estimate Economic Value Added (EVA) of RST Ltd.
11. Tender Ltd has earned a net profit of ` 15 lacs after tax at 30%. Interest cost charged by
financial institutions was ` 10 lacs. The invested capital is ` 95 lacs of which 55% is debt.
The company maintains a weighted average cost of capital of 13%. Required,
(a) Compute the operating income.
(b) Compute the Economic Value Added (EVA).
(c) Tender Ltd. has 6 lac equity shares outstanding. How much dividend can the
company pay before the value of the entity starts declining?
12. The following information is given for 3 companies that are identical except for their capital
structure:
Orange Grape Apple
Total invested capital 1,00,000 1,00,000 1,00,000
Debt/assets ratio 0.8 0.5 0.2
Shares outstanding 6,100 8,300 10,000
Pre tax cost of debt 16% 13% 15%
Cost of equity 26% 22% 20%
Operating Income (EBIT) 25,000 25,000 25,000
The tax rate is uniform 35% in all cases.

(i) Compute the Weighted average cost of capital for each company.
(ii) Compute the Economic Valued Added (EVA) for each company.
(iii) Based on the EVA, which company would be considered for best investment? Give
reasons.
(iv) If the industry PE ratio is 11x, estimate the price for the share of each company.
(v) Calculate the estimated market capitalisation for each of the Companies.

13. Delta Ltd.’s current financial year’s income statement reports its net income as
` 15,00,000. Delta’s marginal tax rate is 40% and its interest expense for the year was
` 15,00,000. The company has ` 1,00,00,000 of invested capital, of which 60% is debt. In
addition, Delta Ltd. tries to maintain a Weighted Average Cost of Capital (WACC) of 12.6%.
(i) Compute the operating income or EBIT earned by Delta Ltd. in the current year.
(ii) What is Delta Ltd.’s Economic Value Added (EVA) for the current year?
(iii) Delta Ltd. has 2,50,000 equity shares outstanding. According to the EVA you
computed in (ii), how much can Delta pay in dividend per share before the value of
the company would start to decrease? If Delta does not pay any dividends, what
would you expect to happen to the value of the company?
14. The following data pertains to XYZ Inc. engaged in software consultancy business as on 31
December 2010.
($ Million)
Income from consultancy 935.00
EBIT 180.00
Less: Interest on Loan 18.00
EBT 162.00
Tax @ 35% 56.70
105.30
Balance Sheet
($ Million)
Liabilities Amount Assets Amount
Equity Stock (10 million 100 Land and Building 200
share @ $ 10 each) Computers & Softwares 295
Reserves & Surplus 325 Current Assets:
Loans 180 Debtors 150
Current Liabilities 180 Bank 100
Cash 40 290
785 785
With the above information and following assumption you are required to compute
(a) Economic Value Added ®
(b) Market Value Added.

Assuming that:
(i) WACC is 12%.
(ii) The share of company currently quoted at $ 50 each
15. Herbal Gyan is a small but profitable producer of beauty cosmetics using the plant Aloe
Vera. This is not a high-tech business, but Herbal’s earnings have averaged around ` 12
lakh after tax, largely on the strength of its patented beauty cream for removing the pimples.
The patent has eight years to run, and Herbal has been offered ` 40 lakhs for the patent
rights. Herbal’s assets include ` 20 lakhs of working capital and ` 80 lakhs of property,
plant, and equipment. The patent is not shown on Herbal’s books. Suppose Herbal’s cost of
capital is 15 percent. What is its Economic Value Added (EVA)?
16. Constant Engineering Ltd. has developed a high tech product which has reduced the
Carbon emission from the burning of the fossil fuel. The product is in high demand. The
product has been patented and has a market value of ` 100 Crore, which is not recorded in
the books. The Net Worth (NW) of Constant Engineering Ltd. is ` 200 Crore. Long term
debt is ` 400 Crore. The product generates a revenue of ` 84 Crore. The rate on 365 days
Government bond is 10 percent per annum. Market portfolio generates a return of 12
percent per annum. The stock of the company moves in tandem with the market. Calculate
Economic Value added of the company.
ANSWERS/ SOLUTIONS
Answers to Theoretical Questions
1. Please refer paragraph 6.2
2. Please refer paragraph 5
Answers to the Practical Questions
1. VALUATION BASED ON MARKET PRICE
Market Price per share ` 400
Thus value of total business is (` 400 x 1.5 Cr.) ` 600 Cr.
VALUATION BASED ON DISCOUNTED CASH FLOW
Present Value of cash flows
(` 250 cr x 0.893) + (` 300 cr. X 0.797) + ( ` 400 cr. X 0.712 ) = ` 747.15 Cr.
Value of per share (` 747.15 Cr. / 1.5 Cr) ` 498.10 per share

RANGE OF VALUATION
Per Share ` Total `
Cr.
Minimum 400.00 600.00
Maximum 498.10 747.15
2. (i) Computation of Business Value

(` Lakhs)
77 110
Profit before tax
1 − 0.30
Less: Extraordinary income (8)
Add: Extraordinary losses 10
112
Profit from new product (` Lakhs)
Sales 70
Less: Material costs 20
Labour costs 12
Fixed costs 10 (42) 28
140.00
Less: Taxes @30% 42.00
Future Maintainable Profit after taxes 98.00
Relevant Capitalisation Factor 0.14
Value of Business (`98/0.14) 700
(ii) Determination of Market Price of Equity Share

Future maintainable profits (After Tax) ` 98,00,000
Less: Preference share dividends 1,00,000 shares of ` 100 @ 13% ` 13,00,000
Earnings available for Equity Shareholders ` 85,00,000
No. of Equity Shares 50,00,000
` 85,00,000 ` 1.70
Earning per share = =
50,00,000
PE ratio 10
Market price per share ` 17

3. Projected Balance Sheet

Year 1 Year 2 Year 3 Year 4
Fixed Assets (40% of Sales) 9,600 11,520 13,824 13,824
Current Assets (20% of Sales) 4,800 5,760 6,912 6,912
Total Assets 14,400 17,280 20,736 20,736
Equity 14,400 17,280 20,736 20,736
Projected Cash Flows:-

Year 1 Year 2 Year 3 Year 4
Sales 24,000 28,800 34,560 34,560
PBT (10% of sale) 2,400 2,880 3,456 3,456
PAT (70%) 1,680 2,016 2,419.20 2,419.20
Depreciation 800 960 1,152 1,382
Addition to Fixed Assets 2,400 2,880 3,456 1,382
Increase in Current Assets 800 960 1,152 -
Operating cash flow (FCFF) (720) (864) (1,036.80) 2,419.20
Projected Cash Flows:-
Present value of Projected Cash Flows:-
Cash Flows PVF at 15% PV
-720 0.870 -626.40
-864 0.756 -653.18
-1,036.80 0.658 -682.21
-1,961.79
Residual Value - 2419.20/0.15 = 16,128

Present value of Residual value = 16128/(1.15) 3
= 16128/1.521 = 10603.55
Total shareholders’ value = 10,603.55 – 1,961.79 = 8,641.76
Pre strategy value = 1,400 / 0.15 = 9,333.33
 Value of strategy = 8,641.76 – 9,333.33 = – 691.57
Conclusion: The strategy is not financially viable

4. (i) Net asset value

H Ltd. ` 1300 Crores − ` 300 Crores
= ` 285.71
3.50 Crores
B Ltd. ` 31.50 Crores
= ` 48.46
0.65 Crores
(ii) Earning capitalization value
H Ltd. ` 300 Crores / 0.08
= ` 1071.43
3.50 Crores
B Ltd. ` 10 Crores / 0.08
= ` 192.31
0.65 Crores
(iii) Fair value
H Ltd. ` 285.71 1 + ` 1071.43  3
= ` 875
4
B Ltd. ` 48.46  1 + ` 192.31 3
= ` 156.3475
4
Exchange ratio `156.3475/ `875 = 0.1787
H Ltd should issue its 0.1787 share for each share of B Ltd.
Note: In above solution it has been assumed that the contingent liability will
materialize at its full amount.
5. Price/share of AB Ltd. for determination of number of shares to be issued
= (` 570 + ` 430)/2 = ` 500
Value of XY Ltd based on future cash flow capitalization
(105x0.93)+(120x0.86)+(125x0.79)+(120x0.74)x(300x0.68) ` lakhs 592.40
Value of XY Ltd based on net assets ` lakhs 250.00
Average value (592.40+250)/2 421.20
No. of shares in AB Ltd to be issued ` 4,21,20,000/500 Nos. 84240
Basis of allocation of shares
Fully paid equivalent shares in XY Ltd. (20+5) lakhs 2500000
Distribution to fully paid shareholders 84240x20/25 67392
Distribution to partly paid shareholders 84240-67392 16848
6. Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:-

FCFF1
Value of Firm = V 0 =
K c − gn
Where –
FCFF1 = Expected FCFF in the year 1
Kc= Cost of capital
gn = Growth rate forever
Thus, ` 1800 lakhs = ` 54 lakhs /(Kc-g)
Since g = 9%, then K c = 12%
Now, let X be the weight of debt and given cost of equity = 20% and cost o f debt = 10%,
then 20% (1 – X) + 10% X = 12%
Hence, X = 0.80, so book value weight for debt was 80%
 Correct weight should be 60 of equity and 72 of debt.
 Cost of capital = K c = 20% (60/132) + 10% (72/132) = 14.5455% and correct firm’s value
= ` 54 lakhs/(0.1454 – 0.09) = ` 974.73 lakhs.
7. High growth phase :
ke = 0.10 + 1.15 x 0.06 = 0.169 or 16.9%.
kd = 0.13 x (1-0.3) = 0.091 or 9.1%.
Cost of capital = 0.5 x 0.169 + 0.5 x 0.091 = 0.13 or 13%.
Stable growth phase :
ke = 0.09 + 1.0 x 0.05 = 0.14 or 14%.
kd = 0.1286 x (1 - 0.3) = 0.09 or 9%.
Cost of capital = 0.6 x 0.14 + 0.4 x 0.09 = 0.12 or 12%.
Determination of forecasted Free Cash Flow of the Firm (FCFF)
(` in crores)
Yr. 1 Yr. 2 Yr 3 Yr. 4 Terminal
Year
Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Capital Expenditure 96 115.20 138.24 165.89 -
Less Depreciation
∆ Working Capital 100.00 120.00 144.00 172.80 103.68
Free Cash Flow (FCF) 56.00 67.20 80.64 96.77 375.32

Alternatively, it can also be computed as follows:

(` in crores)
Yr. 1 Yr. 2 Yr 3 Yr. 4 Terminal
Year
Revenue 2,400 2,880 3,456 4,147.20 4,561.92
EBIT 360 432 518.40 622.08 684.29
EAT 252 302.40 362.88 435.46 479.00
Add: Depreciation 240 288 345.60 414.72 456.19
492 590.40 708.48 850.18 935.19
Less: Capital Exp. 336 403.20 483.84 580.61 456.19
 WC 100.00 120.00 144.00 172.80 103.68
56.00 67.20 80.64 96.77 375.32
Present Value (PV) of FCFF during the explicit forecast period is:
FCFF (` in crores) PVF @ 13% PV (` in crores)

56.00 0.885 49.56
67.20 0.783 52.62
80.64 0.693 55.88
96.77 0.613 59.32
` 217.38
Terminal Value of Cash Flow

375.32
= ` 18,766.00Crores
0.12 - 0.10
PV of the terminal, value is:
1
` 18,766.00Crores x = ` 18,766.00Crores x 0.613 = ` 11,503.56 Crores
(1.13)4
The value of the firm is :

` 217.38 Crores + ` 11,503.56 Crores = ` 11,720.94 Crores

8. Determination of forecasted Free Cash Flow of the Firm (FCFF)

(` in crores)
Yr. 1 Yr. 2 Yr 3 Terminal Year

Revenue 9000.00 10800.00 12960.00 13996.80
COGS 3600.00 4320.00 5184.00 5598.72
Operating Expenses 1980.00* 2376.00 2851.20 3079.30
Depreciation 720.00 864.00 1036.80 1119.74
EBIT 2700.00 3240.00 3888.00 4199.04
Tax @30% 810.00 972.00 1166.40 1259.71
EAT 1890.00 2268.00 2721.60 2939.33
Capital Exp. – Dep. 172.50 198.38 228.13 -
∆ Working Capital 375.00 450.00 540.00 259.20
Free Cash Flow (FCF) 1342.50 1619.62 1953.47 2680.13
* Excluding Depreciation.
Present Value (PV) of FCFF during the explicit forecast period is:
FCFF (` in crores) PVF @ 15% PV (` in crores)

1342.50 0.8696 1167.44
1619.62 0.7561 1224.59
1953.47 0.6575 1284.41
3676.44
PV of the terminal, value is:

2680.13 1
x = ` 38287.57 Crore x 0.6575 = ` 25174.08 Crore
0.15 - 0.08 (1.15)3
The value of the firm is :

` 3676.44 Crores + ` 25174.08 Crores = ` 28,850.52 Crores
9. Financial Leverage = PBIT/PBT
1.5 = PBIT / (PBIT – Interest)

1.5 = PBIT / (PBIT – 40)

1.5 (PBIT – 40) = PBIT

1.5 PBIT – 60 = PBIT
1.5 PBIT – PBIT = 60
0.5 PBIT = 60
60
or PBIT = = `120 lakhs
0.5
NOPAT = PBIT – Tax = `120 lakhs (1 – 0.30) = `84 lakhs.

Weighted Average Cost of Capital (WACC)
= 14%  (300 / 700) + (1 – 0.30)  (10%)  (400 / 700) = 10%
EVA = NOPAT – (WACC  Total Capital)

EVA = `84 lakhs – 0.10  ` 700 lakhs
EVA = ` 14 lakhs
10. Cost of Equity as per CAPM

ke = Rf + β x Market Risk Premium
= 8.5% + 1.36 x 9%
= 8.5% + 12.24% = 20.74%
Cost of Debt kd = 11%(1 – 0.30) = 7.70%
E D
WACC (ko) = ke x + kd x
E+D E+D
125 40
= 20.74 x + 7.70 x = 15.71 + 1.87 = 17.58%
165 165
Taxable Income = ` 25,00,000/(1 - 0.30)
= ` 35,71,429 or ` 35.71 lakhs
Operating Income = Taxable Income + Interest
= ` 35,71,429 + ` 4,40,000
= ` 40,11,429 or ` 40.11 lacs
EVA = EBIT (1-Tax Rate) – WACC x Invested Capital

= ` 40,11,429 (1 – 0.30) – 17.58% x ` 1,65,00,000

= ` 28,08,000 – ` 29,00,700 = - ` 92,700
11. Taxable Income = ` 15 lac/(1-0.30)
= ` 21.43 lacs or ` 21,42,857
Operating Income = Taxable Income + Interest
= ` 21,42,857 + ` 10,00,000
= ` 31,42,857 or ` 31.43 lacs
EVA = EBIT (1-Tax Rate) – WACC x Invested Capital
= ` 31,42,857(1 – 0.30) – 13% x ` 95,00,000
= ` 22,00,000 – ` 12,35,000 = ` 9,65,000
` 9,65,000
EVA Dividend = = ` 1.6083
` 6,00,000
12. (i) Working for calculation of WACC
Orange Grape Apple

Total debt 80,000 50,000 20,000
Post tax Cost of debt 10.40% 8.45% 9.75%
Equity Fund 20,000 50,000 80,000
WACC
Orange: (10.4 x 0.8) + (26 x 0.2) = 13.52%
Grape: (8.45 x 0.5) + (22 x 0.5) = 15.225%
Apple: (9.75 x 0.2) + (20 x 0.8) = 17.95%
(ii)
Orange Grape Apple

WACC 13.52 15.225 17.95
EVA [EBIT (1-T)-(WACC x Invested Capital)] 2,730 1,025 -1,700
(iii) Orange would be considered as the best investment since the EVA of the company
is highest and its weighted average cost of capital is the lowest

(iv) Estimated Price of each company shares
Orange Grape Apple

EBIT (`) 25,000 25,000 25,000
Interest (`) 12,800 6,500 3,000
Taxable Income (`) 12,200 18,500 22,000
Tax 35% (`) 4,270 6,475 7,700
Net Income (`) 7,930 12,025 14,300
Shares 6,100 8,300 10,000
EPS (`) 1.30 1.45 1.43
Stock Price (EPS x PE Ratio) (`) 14.30 15.95 15.73
Since the three entities have different capital structures they would be exposed to
different degrees of financial risk. The PE ratio should therefore be adjusted for the
risk factor.
(v) Market Capitalisation
Estimated Stock Price (`) 14.30 15.95 15.73
No. of shares 6,100 8,300 10,000
Estimated Market Cap (`) 87,230 1,32,385 1,57,300
13. (i) Taxable income = Net Income /(1 – 0.40)
or, Taxable income = ` 15,00,000/(1 – 0.40) = ` 25,00,000
Again, taxable income = EBIT – Interest
or, EBIT = Taxable Income + Interest
= ` 25,00,000 + ` 15,00,000 = ` 40,00,000
(ii) EVA = EBIT (1 – T) – (WACC  Invested capital)
= ` 40,00,000 (1 – 0.40) – (0.126  ` 1,00,00,000)
= ` 24,00,000 – ` 12,60,000 = ` 11,40,000
(iii) EVA Dividend = ` 11,40,000/2,50,000 = ` 4.56
If Delta Ltd. does not pay a dividend, we would expect the value of the firm to increase
because it will achieve higher growth, hence a higher level of EBIT. If EBIT is higher, then
all else equal, the value of the firm will increase.

14. (a) Determination of Economic Value Added (EVA)
$ Million
EBIT 180.00
Less: Taxes @ 35% 63.00
Net Operating Profit after Tax 117.00
Less: Cost of Capital Employed [W. No.1] 72.60
Economic Value Added 44.40
(b) Determination of Market Value Added (MVA)
$ Million
Market value of Equity Stock [W. No. 2] 500
Equity Fund [W. No. 3] 425
Market Value Added 75
Working Notes:
(1) Total Capital Employed

Equity Stock $ 100 Million
Reserve and Surplus $ 325 Million
Loan $ 180 Million
$ 605 Million
WACC 12%
Cost of Capital employed $ 605 Million х 12% $ 72.60 Million
(2) Market Price per equity share (A) $ 50
No. of equity share outstanding (B) 10 Million
Market value of equity stock (A) х (B) $ 500 Million
(3) Equity Fund
Equity Stock $ 100 Million
Reserves & Surplus $ 325 Million
$ 425 Million

15. EVA = Income earned – (Cost of capital x Total Investment)

Total Investments
Particulars Amount
Working capital ` 20 lakhs
Property, plant, and equipment ` 80 lakhs
Patent rights ` 40 lakhs
Total ` 140 lakhs
Cost of Capital 15%

EVA= ` 12 lakh – (0.15 x ` 140 lakhs) = ` 12 lakh – ` 21 lakh = -` 9 lakh
Thus, Herbal Gyan has a negative EVA of ` 9 lakhs.
16. EVA = Income Earned – (Cost of Capital x Total Investment)
Total Investments
Amount (` Crore)
Net Worth 200.00
Long Term Debts 400.00
Patent Rights 100.00
Total 700.00
E D
WACC (ko) = ke  + kd 
E+D E+D
300 400
= 12  + 10 
700 700
= 5.14% + 5.71% = 10.85%
EVA = Profit Earned – WACC x Invested Capital
= ` 84 crore – 10.85% x ` 700 crore
= ` 8.05 crore

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12

© The Institute of Chartered Accountants of India

1. CONCEPTUAL FRAMEWORK OF VALUATION

© The Institute of Chartered Accountants of India

2. IMPORTANT TERMS ASSOCIATED WITH VALUATION

© The Institute of Chartered Accountants of India

3. APPROACHES/ METHODS OF VALUATION

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

3.1.2 Net Realizable Value

Total Liabilities (A) 20,000 20,000

Non-Current Assets (B)

Current Assets (C)

Net Assets (B) + (C) – (A) 1,00,000 1,05,000

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

4. MEASURING COST OF EQUITY

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

The pre-tax cost of debt is 12%. Assume a tax regime of 30%.

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Calculation of Earning Value Per Share

(b) Equity Value of Company

Shareholders' funds 800

© The Institute of Chartered Accountants of India

6. OTHER APPROACHES TO VALUE MEASUREMENT

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Business Segment Capital-to-Sales Segment Sales Theoretical Values

Business Segment Capital-to-Sales Segment Sales Theoretical Values

4,005,000+ 2,880,000+ 5,650,000

6.3 Economic Value Added (EVA)

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

EBIT 410 Equity 700

Step II: Finding out the Invested Capital:

© The Institute of Chartered Accountants of India

6.4 Market Value Added (MVA)

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(b) Discount these FCFs using the WACC

Step b: Applying the WACC to find out the discounted values:

Step c: Finding out the proper TV:

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7. ARRIVING AT FAIR VALUE

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TEST YOUR KNOWLEDGE

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You are required to:

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© The Institute of Chartered Accountants of India

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